BofA: War premium has not yet dissipated in US bond yields, recommends buying 5-year and steepening curve.

With the U.S. stock market having fully recovered all the lost ground since the outbreak of the Iran war, and the U.S. dollar index giving back the safe-haven gains from the early stages of the conflict, there is one market that is still on edge - the U.S. Treasury market. According to the latest research report from the Bank of America strategists team, the U.S. bond yields still contain an "excess risk premium" related to the Middle East conflict, and this expectation gap has created a rare trading opportunity. Led by Mark Cabana, the Bank of America strategists team recommends investors to buy mid-range bonds in the yield curve - usually referring to 5-year mid-term government bonds - and bet on a steepening yield curve. The core logic of this strategy is based on three pillars: the war premium will eventually fade, the Fed is about to usher in a dovish leader, and the peak supply of long-term bonds has not been fully absorbed. Since the outbreak of the Iran war on February 28th, the U.S. stock market has fully recovered lost ground after a brief panic, with the Dow and S&P 500 indices returning to pre-conflict levels; and the ultimate safe-haven asset, the U.S. dollar, has also given back most of its gains after soaring in the early stages of the war. However, the U.S. 10-year Treasury yield was still at 4.26% as of Monday - about 30 basis points higher than pre-war levels. "Other asset classes have already shrugged off the Middle East situation, but only the U.S. bonds are still pricing in the war." The Cabana team wrote in the report. This pricing anomaly means that either the stock and currency markets are too optimistic, or the bond market is too pessimistic. Bank of America leans towards the latter. Strategists further point out that even if the Middle East situation deteriorates again and oil prices spike, this dynamic could continue. The reason is that a prolonged Middle East crisis will drag down global economic growth, thereby strengthening the necessity for the Fed to cut interest rates - which is a direct positive for mid-term bonds. The most noteworthy factor in the Bank of America report is not oil prices or inflation data, but rather a systemic change - the Federal Reserve under Kevin Warsh's leadership. Although Warsh's own monetary policy stance has historically leaned towards hawkishness, the Bank of America strategists believe that the current economic weakness will force any Federal Reserve Chairman to adopt a more dovish stance. Recent economic data - from manufacturing PMI to consumer confidence index - all indicate that the momentum of the U.S. economy is declining. Meanwhile, the expanding federal deficit and continued high levels of Treasury issuance are putting structural pressure on long-term bonds (10 years and above). The imbalance between supply and demand means that even if a rate-cut cycle begins, the downward space for long-term yields will be limited. Therefore, Bank of America strategists recommend buying mid-range bonds in the yield curve and trading on a steepening yield curve, expecting these trades to rise as the market increases its bets on Fed rate cuts. In short, the yield curve describes the relationship between yields of government bonds with different maturities. Under normal circumstances, long-term bond yields are higher than short-term bond yields. "Steepening" refers to the situation where short-term yields decline faster than long-term yields, leading to a widening spread between the two. Bank of America recommends buying 5-year mid-term bonds, betting that these bonds in this range will be the biggest beneficiaries of rate cut expectations. Compared to the more rate-sensitive 2-year bonds, 5-year bonds provide higher interest income; and compared to the 10-year and longer bonds facing supply pressure, the duration risk of 5-year bonds is more manageable. Data shows that although the 10-year U.S. Treasury yield has fallen from its high point of 4.48% at the end of March, it is still significantly higher than at the beginning of the year. Bank of America believes that as the market focus shifts from geopolitics back to macroeconomic fundamentals, this premium will further narrow. At the end of the report, the Cabana team gives a clear conclusion: "We expect U.S. Treasury yields to decline, the yield curve to steepen, especially as the market refocuses on macroeconomic fundamentals, the turnover of Fed leadership, and the supply of U.S. Treasury bonds."